macroeconomic and industry analysis -...
TRANSCRIPT
INTRODUCTION
To determine a proper price for a firm’s stock, security analyst must forecast the dividend & earnings that can be expected from the firm FUNDAMENTAL ANALYSIS
However, fundamental analysis must consider the business environment in which the firm operates
Macroeconomic and industry circumstances might have a greater influence on profits than the firm’s relative performance within the industry
VALUATION PROCESS
There two general approaches to the valuation process:
1. Top down
Involves three steps
2. Bottom up
Stock picking approach
Both can be implemented either by fundamentalists or technicians
The difference between the two approaches is the perceived importance of the economy and a firm’s industry on the valuation of a firm and its stock
THE IMPORTANCE OF ANALYZE THE ECONOMY OUTLOOK
You own shares of the strongest and the most successful firm.
1. If you own the shares during a strong economic expansion, the sales and earnings of the firm will increase and your RoR should be high
2. If you own the shares during a major economic recession, the sales, earnings, cash flows of the firm would decline, the price of the stock would be stable or decline
VALUATION PROCESS
Business analysis
Business cycle, monetary-fiscal policy, economic indicators, government policy, world event & foreign
trade, public attitude of optimism or pessimism, inflation, GDP growth, unemployment, productivity
Industry analysis
Industry structure, competition, supply-demand relationship, product quality,
cost element, government regulation, etc
Company analysis Earnings forecast,
dividend, etc
THREE-STEP VALUATION PROCESS
1. Analysis of alternative economies
Decide how to allocate investment funds among countries to bonds, stocks, and cash
2. Analysis of alternative industries
Based upon the economic & market analysis, determine which industries will prosper and which industries will suffer on a global basis and within countries
3. Analysis of individual companies and stocks
Following the analysis of the industries, determine which companies within these industries will prosper and which stocks are undervalued
KEY ECONOMIC INDICATORS
Government has two broad classes of macroeconomic tools: those that affect the demand for goods and services, and those that affect the supply
The US postwar history focused on demand-side policy (government spending, tax levels, monetary policy)
Since 1980s supply-side economics (enhancing the productive capacity of the economy, the appropriateness of the incentives to work, innovate, national policies on education, infrastructure such communication & transportation systems, research & development)
KEY ECONOMIC INDICATORS
1. Gross Domestic Product (GDP)
The measure of the economy’s total production of goods and services
Rapidly growing GDP indicates an expanding economy with ample opportunity for a firm to increase sales
Another economy’s output measure is industrial production a measure of economic activity narrowly focused on the manufacturing side of the economy
KEY ECONOMIC INDICATORS
2. Employment
Unemployment rate is the percentage of the total labor force (those who are working or seeking employment) to find work
The rate measures the extent to which the economy is operating at full capacity
Analysts also look at the factor capacity utilization rate, which is the ratio of actual output from factories to potential output
KEY ECONOMIC INDICATORS
3. Inflation
Inflation is the rate at which the general level of prices is rising
High rates of inflation are associated with overheated economies, where demand for goods and services is outstripping productive capacity, which leads to upward pressure on prices
Government stimulates their economies enough to maintain nearly full employment, but not so much as to bring on inflationary pressure
KEY ECONOMIC INDICATORS
4. Interest rates
High interest rates reduce the present value of future cash flows, reducing the attractiveness of investment opportunities
Real interest rate is key determinant of business investment expenditures
Demand for housing & high-priced consumer durables such as automobiles, is highly sensitive to interest rates because interest rates affect interest payments
KEY ECONOMIC INDICATORS
5. Budget deficit
Budget deficit of the government is the difference between government spending and revenues
Any budgetary shortfall must be offset by government borrowing
Large amounts of government borrowing can force up interest rates by increasing the total demand for credit in the economy
Economists generally believe excessive government borrowing will crowd out private borrowing and investing by forcing up interest rates and choking off business investment
KEY ECONOMIC INDICATORS
6. Sentiment
Consumers’ and producers’ optimism or pessimism concerning the economy is an important determinant of economic performance
If consumers have confidence in their future income levels, they will be more willing to spend on big-ticket items
Business will increase production and inventory levels if they anticipate higher demand for their products
CENTRAL GOVERNMENT POLICY
1. Fiscal policy
It refers to the government’s spending & tax actions
It is part of demand-side management, a direct way to stimulate or slow the economy
Decrease in government spending deflate the demand for goods and services
Increase in tax immediately drain off income of consumers and result in rapid decrease in consumption
It is created slowly because fiscal policy requires large amount of compromise between executive & legislative institutions
CENTRAL GOVERNMENT POLICY
1. Fiscal policy
To summarize the impact of government fiscal policy look at the government’s budget deficit or surplus (it is simply difference between revenues and expenditures)
Large deficit = government spends more than it should be taken. The effect is the increasing demands for goods (via spending)
CENTRAL GOVERNMENT POLICY
2. Monetary policy
Refers to the manipulation of the money supply to affect the macro economy
Works largely through its impact on interest rates
Increases in money supply lower short-term interest rate, encouraging investment and consumption demand
However, higher money supply leads to a higher price level, and does not have a permanent effect on economic activity
other tool is the discount/interest rate that charges banks on short-term loans and the reserve requirement
FACTORS THAT AFFECT MONETARY VARIABLE: MONEY SUPPLY
Declines in the rate of growth of the money supply business contractions
Increases in the growth rate of money supply business expansions
FACTORS THAT AFFECT MONETARY VARIABLE: MONEY SUPPLY
Open market operation
Federal Reserve
Buy Treasury Bond
Adjust bank reserve money supply
Sell Treasury Bond
Liquidity increases (for those
who sold bonds to the Fed)
The bonds prices rises
Lower interest rates
Filter down corporate bonds
Common stock transaction reduces
To reduce bank reserve
To reduce money supply
To increase interest rate
MONEY SUPPLY AND STOCK PRICE RELATIONSHIP
Changes in the growth rate of money supply consistently lagged stock returns by about one or three months
Stock price adjusts quickly to unexpected changes in money supply growth
Relationship between the two is determined by forecast unanticipated changes in money supply
INFLATION, INTEREST RATE, STOCK PRICE RELATIONSHIP
The relationship is not direct and consistent
Cash flows from stocks can change along with inflation and interest rates
Investors cannot certain whether this change in cash flows will offset the changes in interest rate
The point is, the effect of interest rate changes on stock price will depend on what caused the change in interest rate, and the effect of this event on the expected cash flow on common stock
There has been generally a significant negative relation but this is not always true
Even when the negative relationship is true for the overall market, certain industries may have earnings, cash flows, and dividends that react positively to inflation and interest rate changes. In such an instance, their stock prices would be positively correlated with inflation and interest rates
INFLATION, INTEREST RATE, STOCK PRICE RELATIONSHIP – POSITIVE SCENARIO
Interest rate rises Increase in inflation Corp. earnings increases
Firms increase prices in line
with cost increases
Stock prices might be stable
Negative effect of an
increase in the required RoR
(k) will offset by the increase
in the growth rate of earnings
and dividends (g)
Stock prices might
be increased
Returns on stock
increase in line with
the rate of inflation If g > k
INFLATION, INTEREST RATE, STOCK PRICE RELATIONSHIP – MILD NEGATIVE SCENARIO
Interest rate & Required
return (k) rise Increase in inflation Expected cash flow increase
small increase in prices at
rates below the increase in
the inflation rate and cost
increases
Stock & bond prices decline
Required RoR (k) would
increase, but the growth rate
of dividends (g) would be
constant
Stock prices
would decline
Returns on stock
would decline
k – g spread would
widen
INFLATION, INTEREST RATE, STOCK PRICE RELATIONSHIP – VERY NEGATIVE SCENARIO
Interest rate & Required
return (k) rise Increase in inflation
Growth rate of cash flow
decline
During the period of
inflation, production costs
increase but firms are not
able to increase price at all
which causes a major
decline in profit margin
Stock & bond prices decline
Required RoR (k) would
increase, but the growth
rate of dividends (g) would
decline
Stock prices
would decline
Returns on stock
would decline
Large increase in
k – g spread
INDUSTRY ANALYSIS
Economic performance can vary widely across industries
Industry group show more dispersion in their stock market performance
Small investors can take position in industry performance using mutual funds with an industry focus
Government classifies industries through varied tools: US government divides industries into codes or digits for statistical analysis purposes. First two digits denote very broad industry classification, third and fourth digits define the group more narrowly
SENSITIVITY TO BUSINESS CYCLE
Analyze the implication of the business cycle in an industry
Ex.: cigarette industry is independent of the business cycle, as demand for cigarettes does not seem affected by macroeconomic factors. Cigarette consumption is determined largely by habit
Contrarily, auto industry is highly volatile. In recession, consumers tend to prolong the lives of their cars until their income is higher
SENSITIVITY TO BUSINESS CYCLE
Three factors that determine the sensitivity of a firm’s earnings to the business cycle:
1 Sensitivity of sales depend on the necessities (ex. Food, drugs, medical services), income that is not a crucial determinant of demand (ex. Tobacco products), high sensitive industries to the economy (machine tools, steel, autos, transportation)
2 Operating leverage division between fixed and variable cost. Firms with greater amounts of variable costs will be less sensitive to business conditions, because in economic downturns, the firms can reduce costs as output falls in response to falling sales
SENSITIVITY TO BUSINESS CYCLE Three factors that determine the sensitivity of a firm’s earnings to the business cycle:
2 Operating leverage
Profit for firms with high fixed costs will swing more widely with sales because costs do not move to offset revenue variability high operating leverage because small swings in business conditions can have large impacts on profitability
3 Financial leverage for borrowing interest payments on debt must be paid regardless of sales.
Investors should not always prefer industries with lower sensitivity to the business cycle.
Firms in sensitive industries will have high-beta stocks and are riskier, but they swing higher in upturns the most important issue is the existence of fair compensation for the risks borne
WHY DO INDUSTRY ANALYSIS?
Two reasons for examine macro economy
1. Although the security markets tend to move ahead of the aggregate economy, security markets reflect the strength or weakness of the economy
2. Most of the variables that determine value for the security markets are macro variables such as interest rate, GDP, and corporate earnings.
Therefore, analysis of aggregate equity market contains two components:
1. Analyzing macro variables (ex. monetary policy)
2. Analyzing micro variables (specific variables that affect valuation)
WHY DO INDUSTRY ANALYSIS? It provides answers such as:
1. During any time period, the returns for different industries vary within a wide range, which means that industry analysis is an important part of the investment process
2. The rates of return for individual industry vary over time, then we cannot simply extrapolate past industry performance into the future
3. The rates of return of firms within industries also vary, then analysis of individual companies in an industry is a necessary follow up to industry analysis
4. During any time period, different industries’ risk levels vary within wide ranges, then we must examine and estimate the risk factors for alternative industries
5. Risk measures for different industries remain fairly constant over time, so the historical risk analysis is useful when estimating future risk
SPECIFIC MACRO ANALYSIS
Business cycle and industry sectors
Evaluating an industry’s life cycle
Structural economic changes and alternative industries
Analysis of the competitive environment in an industry
Inflation
Interest rate
International economics
Consumer sentiments
Demographics
Lifestyles
Technology
Politics & Regulations
Competition & Expected Industry Returns
WHY DO COMPANY ANALYSIS
After analyzing a company, deriving an understanding of its strength and risks, you need to compute intrinsic value of the firm’s stock and compare this to its market value to determine if the company’s stock should be purchased
The stock of a wonderful firm with superior management and strong performance measured by sales and earnings growth can be priced so high that the intrinsic value of the stock is below its current market price and should not be acquired
ECONOMIC, INDUSTRY, & STRUCTURAL LINKS TO COMPANY ANALYSIS
Economic and Industry Influence
If economic trends are favorable for an industry, the company analysis should focus on firms in that industry that will benefit from these economic trends
Research analysts should become familiar with the cash flow and risk attributes of the firms
The most attractive firms in the industry will typically have high levels of operating and financial leverage wherein a modest percentage increase in revenue results in a must larger percentage rise in earnings and cash flow
Firms in an industry will have varying sensitivities to economic variables, such as economic growth, interest rates, input costs, and exchange rates
ECONOMIC, INDUSTRY, & STRUCTURAL LINKS TO COMPANY ANALYSIS
Structural influences
Social trends, technology, and political and regulatory influences, can have a major effect on some firms in an industry
Some firms in the industry are able to take advantage of demographic changes or shifts in consumer tastes and lifestyle, or they can invest in technology to lower costs and better serve their customers.
However, although the economy plays a major role in determining overall market trends, and industry groups display sensitivity to economic variables, other structural changes may counterbalance the economic effects, or company management may be able to minimize the impact of economic or industry events on a company. Analysts who are familiar with industry trends and company strategies can issue well-reasoned buy- and sell- recommendations irrespective of the economic forecast.